by Larry Swedroe, Director of Research, 6/14/2018
It’s a great tragedy that despite its obvious importance to everyone, our educational system almost totally ignores the field of finance and investments. This is true unless you go to an undergraduate business school or pursue an MBA in finance.
Eighteenth-century English poet Thomas Gray wrote, “Where ignorance is bliss, Tis folly to be wise.” When it comes to investing, ignorance certainly is not bliss—it pays to be wise. Just ask investors who lost tens of billions of dollars in the Bernard Madoff scandal. Without a basic understanding of how capital markets work, there is no way individuals can make prudent investment decisions.
The sad fact is that surveys have shown fewer than half of U.S. workers have even attempted to estimate how much money they might need in retirement, and many older adults face significant retirement shortfalls. While educational achievement is strongly positively associated with wealth accumulation, research also has found financial literacy has an even stronger and larger effect on wealth.
Households that build up more net wealth may be better able to smooth consumption in retirement, and financial literacy enhances the likelihood people will contribute to their retirement savings. Compounding the problem of lower savings is evidence that less financially literate households experience lower risk-adjusted returns.
Financial Literacy Research
Milo Bianchi contributes to the literature on financial literacy with the study “Financial Literacy and Portfolio Dynamics,” which appeared in the April 2018 issue of The Journal of Finance.
Using data obtained from a large French financial institution, Bianchi observed portfolio choices in a widespread investment product called assurance vie, in which households allocate wealth between relatively safe and relatively risky funds—predefined bundles of bonds or stocks—and are able to rebalance their portfolios over time. Assurance vie contracts are prevalent in France, being the most common way households invest in the stock market.
Bianchi then combined this data with responses to a survey he conducted with the financial institution’s clients. The survey, which ranked investor sophistication levels on a scale between one and seven, allowed him to obtain a broader picture of clients’ financial activities outside the company and of their behavioral characteristics. While investments in assurance vie may not cover a household’s entire portfolio, they often represent a substantial portion of investors’ financial wealth.
The author’s final database incorporated portfolio information at a monthly frequency for 511 of the financial institution’s clients over the period September 2002 to April 2011. On average, the assets it covered were approximately 50% of a household’s financial wealth.
Following is a summary of his findings:
- Financial literacy correlated with demographic variables; in particular, education and wealth.
- Financial literacy was negatively correlated with being female—a gender gap that had been observed in prior studies.
- An additional unit of financial literacy was associated with a 3.5% increase in the probability of holding stocks.
- More literate households experienced higher portfolio returns.
- Controlling for various measures of portfolio risk, the most literate households experienced yearly returns approximately 0.5% higher than the least literate households, relative to an average return of 4.2%. These magnitudes were in line with those found in a recent study of Dutch households.
- There was no evidence that, overall, households with higher financial literacy choose riskier portfolios. Instead, their risk exposure varies systematically with market conditions, allocating more to risky assets when they have higher expected returns. A 1% increase in the expected excess return of risky funds was associated with a 2% increase in the risky share for each unit of financial literacy.
- Decomposing the observed changes in the risky share over time into active changes due to portfolio rebalancing and passive changes induced by differential returns to risky versus riskless funds, Bianchi found that passive changes were relatively more important for less sophisticated households. For the least sophisticated households, passive changes accounted for 64% of the total change in the risky share over 12 months. For the most sophisticated households, by contrast, passive changes accounted for 30%. This demonstrates that households with lower financial literacy display greater portfolio inertia. More educated, older and female investors display lower levels of inertia.
- More literate households were more likely to act as contrarians. Rebalancing, they tended to move their wealth toward funds that had experienced relatively lower returns in the past.
- The returns more sophisticated households actually experienced tended to exceed the returns they would have earned without rebalancing their portfolios. More sophisticated households were more likely to buy funds that provided higher returns than the funds they sold.
Conclusion
Findings such as these demonstrate that financial illiteracy is costly. The fact that our educational system has failed to provide much of the public with what I would consider even a basic level of financial literacy certainly is a tragedy. (The research shows this is not a U.S.-only problem.) But perhaps the bigger tragedy is that so many apparently would rather watch some reality TV show than “invest” the time and effort to become financially literate.
I have now authored or co-authored 16 books on investing, presenting the evidence from academic research. This has been my way of trying to reduce financial illiteracy and help prevent investors from being sheared by the wolves of Wall Street. Others, such as John Bogle and William Bernstein, have written outstanding books on the principles of prudent investing.
The only problem is that the sales of Harlequin romance novels (not that there is anything wrong with them) are far greater than the sales of books on modern portfolio theory and efficient markets, providing one explanation for why investors continue to use nonfiduciaries as their advisors and adopt active management strategies—strategies with a high likelihood of failure.
The bottom line is that the greatest investment you can make, and the one with the highest expected return, is an investment in your own financial literacy. Remember, if you think the price of financial education is too high, just try the price of ignorance.
This commentary originally appeared June 4 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2018, The BAM ALLIANCE®
by Larry Swedroe, Director of Research, 6/11/2018
Environmental, social and governance (ESG) investment strategies—along with the narrower category of socially responsible investing (SRI)—have gained quite a bit of traction in portfolio management in recent years.
In 2016, funds based on such strategies managed about $9 trillion in assets from an overall investment pool of $40 trillion in the United States, according to data from US SIF. In addition, the organization’s 2016 survey of sustainable investment assets found that in the U.S., climate change was the most significant environmental factor influencing asset allocations.
Value Play In ‘Sin’ Stocks?
While ESG investing continues to gain in popularity, economic theory suggests that if a large enough proportion of investors chooses to avoid “sin” businesses, the share prices of such companies will be depressed. They will have a higher cost of capital because they will trade at a lower price-to earnings (P/E) ratio.
Thus, they would offer higher expected returns (which some investors may view as compensation for the emotional “cost” of exposure to what they consider offensive companies).
Academic research has confirmed that the evidence supports the theory.
Higher Fees OK
Interestingly, Arno Riedl and Paul Smeets, authors of the study “Why Do Investors Hold Socially Responsible Mutual Funds?”, which appears in the December 2017 issue of The Journal of Finance, found that investors are willing to pay significantly higher management fees on SRI funds than on conventional funds, and that a majority of them expect such funds to underperform relative to conventional funds.
In other words, investors understand there is a price (in the form of lower expected returns) for expressing their social values, and are willing to pay it.
Impact On Risk?
Jeff Dunn, Shaun Fitzgibbons and Lukasz Pomorski of AQR Capital Management contribute to the literature concerning ESG investing with their February 2017 study, “Assessing Risk through Environmental, Social and Governance Exposures.”
While other studies focused on the impact of ESG/SRI investing on returns, the authors’ focus was on the risk side of the strategy. Just as it is logical to expect that investors shunning certain stocks should lead to those stocks having higher future returns, it is also logical to hypothesize that companies neglecting to manage their ESG exposures may be exposed to higher risk (a wider range of potential outcomes) than their more ESG-focused counterparts.
Risk Of ESG Neglect
The authors used the MSCI ESG database (often referred to as intangible value assessment, or IVA, data) and Barra risk models to determine whether there was any link between the two. The IVA methodology covers a large cross section of companies around the world (more than 5,000 companies as of December 2015 accounting for 97% of the market cap of the MSCI World Index) and assesses how much each company is exposed, and how well it manages its exposure, to a range of environmental, social and governance issues affecting its industry.
Dunn, Fitzgibbons and Pomorski employed the Barra GEM2L risk model to determine forward-looking (ex-ante) risk estimates. Specifically, a stock’s returns are assumed to be driven by a combination of its loadings on systematic risk factors and by firm-specific “idiosyncratic” effects, which are assumed to be uncorrelated across assets. The authors’ sample period is January 2007 to December 2015.
Following is a summary of their findings:
- ESG exposures are informative about the risks of individual firms. This finding is robust to a wide variety of controls and various stock universes (U.S., developed and emerging markets).
- Stocks with the worst ESG exposures have total and stock-specific volatility up to 10-15% higher, and betas up to 3% higher, than stocks with the best ESG exposures.
- ESG scores may help forecast future changes to risk estimates from a traditional risk model. Controlling for contemporaneous risk model estimates, poor ESG exposures predict increased future statistical risks. The magnitude of the effect was relatively modest: A deterioration of ESG score from the 75th to the 25th percentile is associated with about a 1% increase in risk. While this increase might seem small, it may simply reflect the fact that ESG captures risks that are long-run in nature and that may not materialize in the short-to-medium term.
- Across the three dimensions of ESG investing, the social and governance pillars show the strongest correlation to risk. The environmental pillar is only insignificantly related to the various risk measures.
- Stocks in the first (worst) quintile of ESG scores had greater earnings volatility and were less profitable than stocks in the fifth (best) quintile. They also had more exposure to the value factor. Furthermore, they had lower Ohlson scores (a measure of default risk). Additionally, they were smaller companies. Each of these findings is related to risk and highly statistically significant. Stocks in the first quintile also had more exposure to the momentum factor than stocks in the fifth quintile. This also was statistically significant.
- Consistent with theory and prior research, stocks in the first quintile of ESG scores earned 1.8% higher returns than stocks in the fifth quintile. However, while certainly economically significant, this difference was not statistically different from zero at the 5% confidence level (t-stat of 1.2). (Note that this lack of statistical significance could be due to the limitation of the short period covered by the study.) The higher returns might be a premium that investors earn for the displeasure of holding such stocks, possibly as compensation for the additional risks (such as greater earnings volatility, less profitability and greater default risk) these stocks exhibit.
What Risk Exposures Convey
Dunn, Fitzgibbons and Pomorski concluded: “ESG exposures convey information about risk that is not captured by traditional statistical risk models.”
They added: “While the effect is modest in magnitude, it is consistent with ESG exposures conveying some information about risk that is not captured by traditional statistical risk models. Overall, our findings suggest that ESG may have a role in investment portfolios that extends beyond ethical considerations, particularly for investors interested in tilting toward safer stocks. ESG exposures may inform investors about the riskiness of the securities in a way that is complementary to what is captured by traditional statistical risk models.”
The authors included this note of caution: “It would be surprising if ESG were a first-order driver of a stock’s risk beyond what is already captured in a well-constructed statistical risk model. ESG may convey information about, say, the likelihood of a governance scandal, but such a scandal may not materialize for the average company over a relatively short horizon we study here. Moreover, ESG exposures are fairly persistent and stocks with poor ESG profile tend to be poor ESG also in the future.”
The bottom line is that, while ESG investors seem likely to be sacrificing some returns to express their social preferences through their investments, it also seems likely there may be some offsetting benefit, though it may be marginal, in the form of reduced portfolio risk.
This commentary originally appeared May 29 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2018, The BAM ALLIANCE®
by Larry Swedroe, Director of Research
As expert poker player Annie Duke explains in her book, “Thinking in Bets,” one of the more common mistakes amateurs make is the tendency to equate the quality of a decision with the quality of its outcome. Poker players call this trait “resulting.”
In my own book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” I describe this mistake as confusing before-the-fact strategy with after-the-fact outcome. In either case, it is often caused by hindsight bias: the tendency, after an outcome is known, to see it as virtually inevitable.
Duke explains: “When we say ‘I should have known that would happen,’ or, ‘I should have seen it coming,’ we are succumbing to hindsight bias.” She adds that we tend to link results with decisions even though it is easy to point out indisputable examples where the relationship between decisions and results isn’t so perfectly correlated.
For example, she writes, “No sober person thinks getting home safely after driving drunk reflects a good decision or good driving ability.” The lesson, as Duke explains, is that we aren’t wrong just because things didn’t work out, and we aren’t right just because they turned out well.
Don’t Judge Performance By Results
“Fooled by Randomness” author Nassim Nicholas Taleb put it this way: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”
Here’s an example from poker. With one card remaining to be drawn, there are just two players left in the hand. Player X calculates that he has an 86% chance of winning. Based on those odds, he makes a large bet. Unfortunately, he loses the hand, just as he would expect to occur 14% of the times he faced the same situation. If he engaged in resulting, he would change his betting strategy because he would conclude that it was wrong to make such a bet. However, we know that if he made the same decision each time he faced those odds, over the long term, he would be expected to come out way ahead.
Let’s look at another example of resulting. John Smith, a hypothetical investor, works for Google and has nearly his entire portfolio invested in Google stock. He became a multimillionaire based on that strategy. John believes concentrating all your eggs in one basket—a basket that, as a senior executive, he could watch closely—is the right strategy. He thought diversification was only for investors who don’t have his sophistication. Of course, many other, similar situations turned out entirely differently, despite using the same strategy of concentrating risk in what you know. That’s why the saying “the surest way to create a small fortune is to start out with a large one and concentrate your risk” offers such good counsel.
Flawed Strategy
Among the once-great companies whose stock prices collapsed are Polaroid, Eastman Kodak, Digital Equipment, Burroughs and Xerox. However, despite the fact that there are far more Polaroids than Googles—showing John’s strategy is flawed—his outcome convinced him the strategy was right.
As Duke points out, once a belief becomes lodged, it becomes very difficult to dislodge. It takes on a life of its own, leading us to notice only evidence that is confirming, and causing us to experience cognitive dissonance. We then work hard to actively discredit contradicting information, a process called motivated reasoning.
Making matters worse is that research shows being “smart” actually makes certain behavioral biases worse: The smarter you are, the better you are at constructing a narrative that supports your held belief.
Duke cites the research of Richard West, Russell Meserve and Keith Stanovich, who tested the blind-spot bias. They found we are much better at recognizing biased reasoning in others but are blind to recognizing it in ourselves.
Surprisingly, at least to me, West, Meserve and Stanovich also found that the better you were with numbers, the worse the bias—the better you are with numbers, the better you are at spinning those numbers to suit your narrative. Quoting Duke: “Our capacity for self-deception knows no boundaries.” So, what does this have to do with investing?
Invest By Playing The Odds
When it comes to investing, there are no clear crystal balls. Just as in poker, the best we can do is put the odds in our favor and invest (bet) accordingly.
As I recently discussed, using factor data from Dimensional Fund Advisors from 2007 through 2017, the value premium (the annual average difference in returns between value stocks and growth stocks) was -2.3%. Unfortunately, resulting, hindsight bias and recency bias led many to conclude it was a mistake to invest in, or overweight, value stocks.
Another way to look at the situation is that, over 10-year periods since 1927, value stocks outperformed growth stocks 86% of the time—the same percentage as in the aforementioned poker hand. The value premium’s now-decade-long underperformance was not unexpected, in the sense that in 14% of the alternative universes that might have shown up, we expected value stocks to underperform.
Similarly, again using Dimensional Fund Advisors data, the market-beta premium has been negative (U.S. stocks underperformed riskless one-month Treasury bills) in 9% of the 10-year periods since 1927.
In other words, investing is risky. To be successful, you must accept that fact there will be periods, even very long ones, when the right strategy leads to poor outcomes. Even at 20-year horizons, the market beta premium has been negative 3% of the time. That is why Warren Buffett has said investing is simple, but not easy. It takes discipline to earn risk premiums.
Summary
One of the hardest things for investors to do is to stay disciplined when their strategy delivers poor results. It certainly is possible that the strategy was wrong. To determine if that is the case, look to see if the assumptions behind the strategy were correct. Seek the truth, whether it aligns with your beliefs or not. For investors, the truth lies in the data. When your theory isn’t supported by the data, throw out your theory.
While it’s certainly not an investment book, investors can learn many lessons from Duke’s “Thinking in Bets.”
This commentary originally appeared May 11 on ETF.com
Every year, the markets provide us with some important lessons about prudent investment strategy. Last year taught us 11 lessons, some of which the markets have covered many times before. In this BAM ALLIANCE client webcast, Director of Research Larry Swedroe explains what investors can learn from 2015.
Approximate running time: 35 minutes.
About the Presenter
Larry Swedroe, Director of Research
The BAM ALLIANCE
Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.
To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored six more books:
What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)
He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for CBSNews.com, Seeking Alpha, and Index Investor Corner on ETF.com.
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of JDH Wealth Management. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, JDH Wealth Management
Larry Swedroe, Director of Research
My book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,”covered 77 common errors I believe investors commit all too often. I know today there’s at least one more I should have included: discussing individual stock buys or sells at the water cooler.
Evidence from the field of psychology emphasizes the strength of face-to-face communication between individuals who frequently interact in producing and altering beliefs. Specifically, as it relates to investing, the study “Social Interaction and Stock Market Participation,” which appeared in the February 2004 issue of The Journal of Finance, found that social interaction leads to greater stock market participation. Read more
An overwhelming amount of evidence exists to clearly demonstrate that, in aggregate, active management is a loser’s game. And this is true regardless of whether markets are efficient or inefficient, or whether they are in a bull or bear phase.
But if the evidence doesn’t convince you, perhaps some of the market’s smartest and most-well-respected investors will. What’s more, you just may be surprised about who thinks what when it comes to indexing and passive management. Take the following quiz, and see if you can match the quote below to the person who said it. Read more
Good Reads
BAM ALLIANCE’s National Thought Leaders share a common love of the written word, as they have used their books and blog posts to help educate and enlighten investors about the proponents of following an evidence-based approach. We asked five of the BAM ALLIANCE’s published authors — who collectively have written or co-written almost 30 books (and counting) — for the works that have influenced them the most in their careers and lives, both in financial and non-financial categories.
10 “sure things” for 2014: Not so much
Larry Swedroe, The BAM Alliance, Director of Research
At the beginning of each year, I compile a list of predictions that financial gurus and industry experts tell us are a “sure thing.” And each year, I track how many of these predictions actually come true. So, it’s now time for our second quarterly review of 10 financial predictions that pundits forecast as certain to occur in 2014.
Keep in mind that if these 10 predictions were really sure things, all — or at least most — of them should have happened. But as the research indicates, past isn’t prologue, and no one is a good forecaster when it comes to performance. As is our practice, we give a score of +1 for a forecast that came true, a -1 for a prediction that turned out to be wrong, and a 0 for one that’s basically a toss-up. Read more
By Larry Swedroe
One of the more persistent investment myths is that it is a winning strategy to sell stocks in May and then wait to buy back into the market around November. The oft-repeated catch phrase is, “Sell in May and go away.”
Well, this year if you sold your stocks in May, you would probably have lost out on some nice gains. The S&P 500 rose from 1883.68 to 1923.57 last month, an increase of 2.1 percent. And that doesn’t include the impact of any dividends.
Of course, the real test of the sell in May theory requires five more months. I ran some numbers looking at returns from May through October in recent years.
I found that while it is true that stocks have provided greater returns from November through April than they have from May through October, since 1926 it has still been advantageous to stay invested in stocks from May through October. In other words, selling in May and going away hasn’t been a good strategy. Read more
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